Foreign revelations

(December 2005) Federal government policy is not usually known for being well timed, but the recent lifting of the foreign property rule (FPR) for RRSPs marks a departure from this truism. Just as our currency and stock markets are approaching three years of strong appreciation, the government has opened the door to unlimited foreign content holdings. So, should portfolios change in light of this new-found freedom?

Perhaps. Valuation is one reason to consider boosting foreign exposure at the expense of the Canadian portfolio allocations. A global portfolio manager recently pointed out that European companies have grown earnings and dividends faster than their U.S. counterparts over the past 15 years. While that’s hardly news, the fact is portfolio managers are finding cheaper, global alternatives to Canadian companies.

When measured by market capitalization, the U.S. accounts for about 49% of the world equity markets, while Europe makes up 28%, according to S&P/Citigroup BMI Global Index Overview. However, when measured in terms of total paid dividends, the U.S. accounts for just 32% of the world and Europe makes up 42%, according to the same global portfolio manager.

Then there’s the fund-flow argument — what I consider a contrarian indicator. Over six years which ended December 1999, the table, “Fund Flows and Rates of Return,” shows the performance of foreign stock funds (as tracked by the Investment Funds Institute Institute of Canada) outpaced Canadian stock funds by nearly six percentage points annually. Back then, mutual fund investors couldn’t get enough of investing in foreign stock funds. While they were in net redemptions through most of 1999, Canadian stock funds sold well in 2000, thanks to a Nortel-driven climb in the TSX.

Subsequent performance demonstrated it was a poor decision to write off Canada, as homegrown stock funds outpaced foreign funds by nearly 11 percentage points annually for the five years and 10 months ending in October 2005.

Now, we have the reverse, both in terms of net sales and trailing returns. The difference is today’s investors have a particular interest in yield-oriented funds. That’s reason enough to consider rebalancing portfolios overstuffed with Canadian stocks and income trusts.

If you generally agree with the idea of broader global diversification, this is a good time to take a second look at your clients’ RRSP portfolios. If representative of the industry, they may be heavily weighted in domestic assets. I suggest checking what your clients hold with other advisors or discount brokers. If they hold individual stocks, there’s a good chance they include income trusts, bank or energy stocks. The holistic approach is to structure the assets you advise in the context of the client’s overall portfolio. However, for competitive reasons, you may run your portion of the portfolio on a stand-alone basis. Whichever way you go, at least be aware of how other assets are invested.

A general rule I use for portfolios is to split the equity portion into two equal parts — one domestic and one foreign (U.S. and overseas). The rule is neatly tied to a portfolio’s equity component. More conservative clients will have a lower equity component and, hence, a lower foreign equity allocation. Accordingly, a higher foreign stock allocation will be appropriate for more aggressive clients with a higher overall allocation to equities.

On the bond side, it’s less clear that diversification is as compelling, at least in developed nations. We keep hearing how low interest rates are in North America. But, as the table entitled “Selected Current Bond Yields” shows, rates are relatively low everywhere for short-, mid- and long-term bonds of many developed countries.

Once you make a decision about foreign allocation, it’s time to implement. Advisors who like greater control may use a combination of regional funds to obtain foreign exposure. But history suggests this is a bad idea since most people, advisors included, are not successful in specialty funds. Such instruments are often volatile and investors tend to buy them at the wrong times (i.e. when the price is too high). Subsequent declines bruise investor confidence and, inevitably, investors sell out just in time to miss a long-awaited rebound.

Practise patience

Most investors also underestimate how long it will take for emerging economies to fully mature. Advisors in the business in the early- to mid-1990s will remember everyone’s infatuation with Latin America, Asia (including Japan) and other emerging markets.

At the end of 1994, there were about 10 Latin American equity funds. Remember the stories about Brazil’s huge potential? Those reports still have merit, but the potential for immature economies to fully develop requires a time frame ranging between 30 and 50 years. Profits will be made during interim periods, as they were in the early 1990s and in recent years, but those are just blips along a lengthy journey. The market hiccups encountered along the way drove investors out of those funds, which closed as a result of shrinking asset bases. Today, only four Latin American funds remain, with net assets of just $148 million across all four. Hence, my preference is for nothing more specialized than an overall emerging markets fund.

As for bond funds, there is limited potential to really diversify into foreign markets. Low rates across the developed world might make the case for emerging markets bonds instead. But be careful: While emerging markets bonds carry equity-like upside potential, they have matching potential downside risk and are thus more appropriately included as part of a portfolio’s equity allocation.

It’s also hard to find these funds. While at one time Fidelity Investments offered an emerging markets bond fund, there are no longer any open- or closed-end funds in Canada dedicated to investing in emerging markets debt.

What’s the best path to getting some of this exposure? Look for broad-based and high-yield foreign bond funds that have the flexibility to buy emerging markets debt when they find good opportunities. Another possibility for securities-licensed advisors are closed-end funds trading on U.S. exchanges. (A good resource is www.etfconnect.com which is run by Nuveen Investments.)

The previous foreign content limits were something of a phantom constraint. Not only were many products available to skirt the limit (albeit at a higher cost), other nations with no foreign content limits still tend to hold modest levels of foreign securities. Many portfolios I’ve constructed rarely contain more than 30% in foreign exposure. However, a modicum of flexibility is always better than too much.

Dan Hallett, CFA, is president of Dan Hallett & Associates Inc., a company that provides independent investment research and a recommended fund list to financial advisors.

(12/09/05)